This article is part of a new series of regular pieces where we will discuss recently issued exchange-traded products (ETPs) which are seen to be innovative or otherwise attempt to improve upon existing strategies available within an ETP wrapper. Our intention is to give the reader a better understanding of those products and highlight potential benefits and risks for investors.
Last time, we examined the Man GLG Europe Plus Source ETF.
RBS Market Access Monthly Leveraged ETFs
In this article we will be analysing the 2X monthly leveraged long and short ETFs from RBS which were launched in mid-February 2011. These products have been designed to mitigate the known issues that exist in daily leveraged products. As we frequently highlight, the mechanism by which most leveraged products are reset daily can result in significant deviations from a simple +2X or -2X the return of the reference index over any holding period longer than one day, as this hypothetical example graphed illustrates.
Leveraged ETFs
First, let’s examine the mechanics of leveraged ETFs and analyse how they achieve their objectives.
Leveraged ETFs are designed to deliver a multiple (positive or negative) of an index return over a finite time horizon, typically one day. A 2X leveraged long ETF has the objective to return twice the performance of its benchmark, e.g. if the index goes up by 2% over a given period (again, typically a single trading day), the leveraged ETF will increase by 4%, less fees and financing costs. In contrast, a 2X leveraged short ETF aims to deliver twice the inverse return of the reference index, i.e. -4% less fees plus an interest component (I will explain the interest/finance component later).
Investors should understand the risks involved in leveraged products, especially the effects of daily compounding and volatility on their returns. Because of the daily rebalancing and the compounding arithmetic involved, investors are not guaranteed to get double the index's return for any holding period longer than one day, in case of daily leveraged products. This issue is generally amplified in periods of high market volatility and can lead to greater losses than anticipated.
Let’s have a look at a simple example to highlight the magnitude of leveraged products: Assume you invest £10,000 in a daily leveraged ETF with the objective of providing twice the daily return of an index. That same day, the market crashes, and the product’s reference index drops by 40%, causing the value of your initial investment to fall by £8,000 and leaving you with just £2,000 in the product. An un-levered ETF tracking the same index would have fallen in tandem with the benchmark and be worth £6,000 at the end of this harrowing day. Now, let’s assume that there's a huge rally the next day and the index rises 60%. Your investment in the un-levered ETF would be worth £9,600 at day’s end. Meanwhile, the leveraged product soars by double the index amount, a full 120%, but that leaves you with only £4,400. Whereas the unleveraged index “only” needs to increase by 67% to get back even after a 40% drop, the leveraged product needs to increase by 500% to recover its losses. Therefore, it is crucial for investors to understand the risks inherent in leveraged products and when using leverage more generally.
Let’s look at another numerical example for a daily leveraged product to highlight the daily rebalancing and the compounding arithmetic issue, if held over several days.
As we can see, the leverage factor is reset on a daily basis. The new index base for the return calculation is always the closing price of the previous day to ensure that this daily performance ratio of 2 is achieved. However, over time this daily resetting of the leverage factor can lead to a divergence between the leveraged ETF and a simple +/- 2X the index’s return. This can be seen in an aggregate performance ratio of 1.76 over the 6 days illustrated in the example above.
Now, let’s compare this case with an example for a monthly 2X leveraged long ETF (the 2X short leveraged ETF would be the exact inverse).
As we can see, here the reset occurs on a monthly basis. The index base for the return calculation is always the closing price of the last reset day to ensure that a monthly performance ratio of 2 is achieved. However, the timing of buying the monthly product in respect to its last reset day is also crucial in order to ensure that the desired 2X leverage ratio is achieved. As the monthly leveraged ETFs are only reset once a month, the leverage factor does not remain steady at 2 between reset days and is therefore only guaranteed if the product is bought on the reset day. If a leveraged long ETF increases in value after a reset day, the fund’s leverage factor will drop below 2. On the other hand, if the ETF decreases in value after the reset day, the leverage factor will be greater than 2. The inverse is true for leveraged short ETFs. For example, if an investor would have bought the monthly leveraged ETF in the above example on the day after the reset day, he would only be guaranteed a leverage factor of 1.96 (104/102) until the next reset day. Therefore, intra-month volatility can impact these products leverage factors; an important issue to keep in mind when these products are bought intra-month, rather than on their reset day.
So by resetting their leverage factor once per month as opposed to daily, these products avoid the issues stemming from compounding--on an intra-month basis. However, those investors choosing to hold these products for a period longer than one month would likely encounter similar issues to those experienced by investors holding daily leveraged ETFs for periods greater than one day. And again, it is important to reiterate that these products leverage factor is guaranteed to be equal to exactly 2 only on their reset date and will vary on an intra-month basis.
It is also worth noting that in the case of swap based leveraged ETFs, the leverage is embedded in the index calculation and does not involve actual engagement in lending/borrowing at the fund level. The mechanism in mutual funds is more complex as they have to engage in actual borrowing/lending to achieve their leverage. However, for the purpose of this article, we will only consider ETFs.
